Private credit – Time to replace those lost dividends?

Following on from my introduction into the world of alternative assets, this article will address one of the fastest-growing yet relatively poorly understood asset classes in the investment world: private credit. Put simply, private credit is non-bank lending, that is, it involves private groups like individuals and fund managers lending directly to business owners. In some countries, this is called ‘shadow banking,’ suggesting some sort of secrecy, but that should not be the inference drawn. Private lending is similar to investing in publicly traded bonds issued by companies or Governments, the only difference being that there is no formal market for the sale of these bonds before their maturity. Investors have flocked to the sector due to the higher returns and capital protection available via the secured nature of most loans.

In 2020, private lending remains nearly the sole domain of large institutions, from Australia’s industry super funds to global sovereign funds, with over 70% of all capital sourced from this sector. In fact, Australia’s FIIG Securities is in some ways a combination of both a private and listed credit market, arranging direct loans with many individual companies or borrower. The global market has grown substantially since the GFC, reaching some $812 billion in 2019 , as companies leveraged up to access ultra-low interest rates. Interestingly, many Australian DIY investors may unwittingly have an exposure to the sector though the likes of KKR’s Credit Income Fund (ASX:KKC) which holds 50% of its portfolio in these unlisted loans.

What are the important terms for private credit investors?

Without going into extensive detail and being too technical, there are four important terms that all private credit investors (either through funds or directly) should understand:

• Capital Ranking – As the Virgin debacle has shown, every bond is a loan to a company and ranks at a different part of the company’s capital structure. The lowest risk is a senior secured or ‘first lien’ loan, which has the first claim over the underlying companies or assets that have been used as security. The scale then moves from unsecured, to subordinated and eventually to mezzanine debt, with risk and expected return increasing along the capital structure.
• Covenants – COVID-19 once again saw ‘debt covenants’ become one of the most commonly quoted terms in the daily news. A covenant refers to the restrictions placed on a borrower regarding the repayment of their loans, similar to a typical residential mortgage. These can include the maximum loan-to-value ratio allowed for a business as a whole, something impacted by falling valuations of other assets, or interest coverage, through which a company must be producing enough profit to fund at least its repayments. A breach of covenants allows the lender to exert substantial influence on the borrower.
• Sponsored or Syndicated – Sponsored lending refers to the increasingly popular strategy where the likes of Blackstone, KKR and other private equity players raise money to then on-lend to the ‘portfolio companies’ that they have purchased via their private equity division. ‘Syndicated,’ on the other hand, refers to loans made via a syndicate of lenders, as in where several funds or companies team up to negotiate terms with a borrower.
• Recoveries – Given the higher risk nature of the private credit market and the lack of credit ratings available, defaults are common and something that professional managers can actually use to add value. A recovery represents the percentage or amount of the lent capital that is recovered following a default event. Experts expect defaults to increase and recoveries to reduce due to the pressures of COVID-19.

What is the attractiveness of private credit?

According to experts, the benefits of private credit are fourfold:

1. Higher incomes – An investment in private credit can be expected to deliver income returns alone of between 5%-15%. Whether the income is at the higher or lower end of that spread depends on the quality and existing indebtedness of the borrower;
2. Diversification – Share and bond markets around the world, driven by the rise of ETF providers, are offering less diversification by the day. Private credit allows investors to access less-well-represented sectors of the global economy and diversify the economic exposure of their portfolios.
3. Patience – In the era of high-frequency trading, leveraged ETFs and an insatiable appetite for information, private lending by its nature requires a buy-and-hold approach. There is no secondary market, so loans do not need to be repriced every day, and businesses can be supported to assist in repayment.
4. Control – One of the biggest differences for institutional investors and fund managers is the ability to control their own destiny. There are many groups in the market, including Think Tank, Moelis, Invesco and others, that have sufficient size to negotiate directly with companies and determine the terms of the loans they make.

Although in its relative infancy in Australia, private credit stands out as a growth sector for the next decade. The sheer dominance of the Australian banks has meant that about 95% of all lending has been controlled by just a few institutions, for many decades. Recent changes to risk weightings have seen the same institutions reduce lending to private business at a time of great need, opening-up huge opportunities for experienced investors with capital to deploy.

Drew Meredith

Drew is publisher of the Inside Network's mastheads and a principal adviser at Wattle Partners.